Managing New Schedule M-3 Disclosures

Beginning
with 2010
tax years,
corporate
and
partnership
entities
that must
file
Schedule
M-3, Net
Income
(Loss)
Reconciliation,
must
report
their
research
and
development
costs for
financial
accounting
purposes
and
reconcile
them with
the amount
of
research
and
experimental
costs
claimable
as a
federal
tax
deduction
under Sec.
174 or
credit
under Sec.
41.
Starting
in 2010,
corporations
must also
report all
nonshareholder
contributions
to capital
during the
year
excludible
from
income
under Sec.
118 on
Schedule
M-3.

The
Sec. 41
credit and
Sec. 118
exclusion
have been
designated
by the IRS
as Tier I
audit
issues.

Research
and
experimental
costs
generally
are those
paid or
incurred
in
connection
with the
taxpayer’s
business
to
discover
information
or dispel
uncertainty
concerning
the
development
of a
product. A
requirement
that
entities
detail in
a
supporting
attachment
each
R&E
expense in
the totals
reported
on
Schedule
M-3 has
been
deferred
until
2012.

Nonshareholder
contributions
to capital
reportable
on
Schedule
M-3 can
include
payments
from
governmental
units and
civic
groups but
must meet
certain
statutory
requirements
and
common-law
tests.

Schedule M-3, Net
Income (Loss)
Reconciliation, is
required for
returns of
corporate and
partnership entities
that report assets of
$10 million or more on
their Schedule L
balance sheet, to
reconcile taxable
income or loss with
financial statement
income or loss. The
IRS introduced
Schedule M-3 effective
for tax years
beginning after
December 31, 2004.
Since then, numerous
changes to the form
have expanded its
reporting
requirements. The most
recent change, for
2010 and following tax
years, requires new
disclosures of
research and
development (R&D)
costs and Sec. 118
exclusions from income
of nonshareholder
contributions to
capital for corporate
filers including S
corporations.1
Entities taxed as
partnerships2
must also disclose
R&D costs but have
no reporting
requirement for the
Sec. 118 exclusion,
since they are not
entitled to it. In
addition, certain Form
1065 filers with
assets less than $10
million are required
to complete Schedule
M-3 if an alternative
computation of gross
assets meets the $10
million threshold or
if a corporate partner
is required to file
the Schedule M-3.

The reporting
requirement for
R&D costs creates
a new level of
transparency for Sec.
174 research and
experimental (R&E)
expenses, including
those claimed as
qualified research
expenses and basic
research payments
for the Sec. 41
credit for
increasing research activities. Although a
supporting attachment
for R&D costs will
not be required for
2010 and 2011 tax
years,3
their amount must
still be reported.
Furthermore, specifics
of exclusion from
income of
nonshareholder
contributions to
capital must be
disclosed in an
attachment even if
there is no book-tax
difference. Since the
Sec. 41 credit and the
Sec. 118 exclusion are
Tier I audit issues,
taxpayers availing
themselves of these
tax benefits should
ensure that there is
adequate documentation
to defend the tax
treatment of these
items. This article
discusses the likely
tax compliance and tax
reporting issues that
Schedule M-3 filers
face when completing
these new lines on
their 2010 and
following Schedules
M-3.

R&D
Expenses Reportable on
Schedule M-3

Corporate taxpayers
should budget for the
additional time that
will likely be
required to accurately
compute and report the
related book-tax
permanent and timing
differences associated
with these
expenditures. Mapping
and classification
issues may arise when
attempting to obtain
the required
information from the
company’s accounting
information system.
The new disclosures
may have reporting
implications for
taxpayers that
apportion R&D
expenses under
cost-sharing
arrangements.4
Also, there may be an
effect on the amount
of expenses that
qualify for the credit
for increasing
research
activities.5

Sec.
174: R&E
Expenses

Reportable R&D
expenses include
R&E expenses under
Sec. 174 that are paid
or incurred by the
taxpayer in connection
with the taxpayer’s
trade or business that
are reasonable in
amount under the
circumstances.6
They include the cost
of obtaining a patent,
such as attorneys’
fees for making and
perfecting a patent
application for a
discovery made by the
taxpayer. Amounts the
taxpayer pays or
incurs for research or
experimentation
carried on in the
taxpayer’s behalf by
another person or
organization also
qualify as R&E
expenditures.7

The costs must be
incurred in the
“experimental or
laboratory
sense,”8
arising from
activities intended to
discover information
to eliminate
uncertainty concerning
the development or
improvement of a
product. Uncertainty
exists if the
information available
to the taxpayer before
undertaking the
research does not
establish either (1)
the capability or
method for developing
or improving the
product or (2) the
appropriate design of
the product. The
nature of the activity
determines whether the
costs qualify, not the
nature of the product
or improvement or the
level of technological
advancement brought
about by it.9

Research
in connection with
literary,
historical, or
similar
projects;12

Acquiring or
improving land used
in connection with
research and
experimentation;13

Acquiring or
improving property
subject to an
allowance for
depreciation or
depletion that is
used in connection
with research and
experimentation;14
and

Ascertaining the
existence, location,
extent, or quality
of mineral deposits,
including oil and
gas.15

The
Code provides three
methods for deducting
R&E costs. First,
the taxpayer may
deduct the expenses in
the year paid or
incurred.16
Second, the taxpayer
may elect to amortize
the expenses over a
period selected by the
taxpayer of not less
than 60 months.17
Only expenses that
would be chargeable to
a capital account
in the absence
of Sec. 174 (except
for expenditures
chargeable to
property that is
depreciable or
depletable) qualify
for the 60-month
amortization method.
The amortization
period under this
method begins with
the month the
taxpayer first
realizes benefits
from the
expenditures. A
benefit is first
realized in the
first month that the
process, formula,
invention, or
similar property is
put to an
income-producing use.18 Third, the
taxpayer may
amortize the
expenditures over a
10-year period
beginning in the
year they are paid
or incurred.19 R&E
expenses not
accounted for using
one of these three
methods must be capitalized.20 The way a
taxpayer treats
R&E expenses for
financial accounting
purposes does not
affect their tax treatment.21

The future results
and benefits of
R&E undertaken by
a taxpayer are
generally uncertain.
If a research project
is abandoned without
realizing any benefits
and the taxpayer has
elected to amortize
the expenditures using
the second or third
method or capitalizes
the expenses, the
expenditures may be
recovered in full as a
loss.22
The same rule would
apply for any
unrecovered cost if a
project initially
thought to be
successful is
abandoned after cost
recovery has
begun.

R&E
expenditures are not
subject to recapture
as ordinary income
upon the sale of the
technology to which
the deduction
relates. Therefore,
if the capital gain
requirements are
otherwise satisfied
upon the sale of the
technology, the
entire gain may be
treated as a capital
gain despite the
prior tax benefit
received by
offsetting R&E
expenditures against
ordinary income.23

The Sec. 174
deduction for
R&E expenditures
must be reduced by
the amount of the
Sec. 41 incremental
research credit for
the year.24 If the taxpayer
capitalizes the
research
expenditures instead
of immediately
taking a deduction
for them, the amount
capitalized must
also be reduced by
the amount of the
research credit.25 The taxpayer
can make an annual
irrevocable election
to take a reduced
research credit
instead of reducing
the research expense
deduction or
capitalized research
costs (Sec. 280C election).26 The effect of
the election is to
reduce the amount of
the research credit
by the amount of tax
saved (using the
highest corporate
tax rate) by not
making a reduction
of the Sec. 174
deduction.

Sec.
41: Incremental
Research Credit

The Economic
Recovery Tax Act of
198127
added a nonrefundable
income tax credit for
certain qualified
research expenses paid
or incurred in
carrying on an active
trade or business. The
Sec. 41 credit for
increasing research
activities currently
provides two methods
for determining the
amount of credit.
Under the “regular”
method, the credit is
equal to the sum of
(1) 20% of the
qualified research
expenditures in a tax
year over a base
amount, plus (2) 20%
of “basic research
payments” to qualified
organizations over a
“qualified
organization base
period amount,” plus
(3) 20% of any amounts
paid or incurred by
the taxpayer to an
energy consortium for
energy research in
connection with
carrying on the
taxpayer’s trade or
business.28

Qualified research
expenses consist of
three categories of
in-house research
expenses and contract
research expenses paid
to third parties.29
In-house research
includes (1) wages for
employees engaged in
the research activity,
(2) cost of supplies
used in the research,
and (3) amounts paid
or incurred to a third
party for the right to
use computers in
conducting the
research.30
Contract research
services are amounts
paid by the taxpayer
to a third person
(other than an
employee of the
taxpayer) for
research.31
Only 65% of the amount
paid for the contract
research services is
taken into account in
computing the research
credit. However, the
amount is increased to
75% for amounts paid
to a qualified
research consortium
for qualified research
on behalf of the
taxpayer and one or
more unrelated
taxpayers32
and to 100% for
amounts paid for
qualified energy
research to an
eligible small
business, an
institution of higher
education, or a
federal
laboratory.33

The qualified
research expense base
amount is computed by
multiplying the
“fixed-base
percentage” by the
taxpayer’s average
annual gross receipts
for the four preceding
years.34
However, the base
amount may not be less
than 50% of the
qualified research
expenses for the
year.35
The fixed-base
percentage is equal to
the percentage that
the aggregate
qualified research
expenses of the
taxpayer after 1983
and before 1989 is of
the aggregate gross
receipts of the
taxpayer for such tax
years.36
The fixed-base
percentage may not
exceed 16%.37
Special computation
rules are provided for
companies that began
having gross receipts
and qualified research
expenses after
1983.38

For tax years
after 2006,
taxpayers may elect
to compute the
credit using the
alternative
simplified credit method.39 The election
may be revoked only
with the consent of
the IRS.40 Under this
method, the credit
is equal to 14% of
the excess of the
qualified research
expenses for the
year over 50% of the
average qualified
research expenses
for the three
preceding tax years.41

Under both
methods, qualified
research must meet
the following
requirements:

The expenditures
must be incurred in
connection with the
taxpayer’s trade or
business and must be
a research cost in
the experimental or
laboratory sense in
accordance with Sec.
174;

The research
must be undertaken
to discover
information that is
technological in
nature
(technological
information test);

The
discovered
information must be
intended to be
useful in the
development of a new
or improved business
component of the
taxpayer (business
component test); and

Substantially
all the research
activities must
constitute elements
of a process of
experimentation for
a qualified purpose
(process-of-experimentation
test).42

The
research credit is
available only for
research expenditures
incurred in carrying
on a trade or
business43
or for research
expenses incurred in a
business in which the
taxpayer already is
engaged. Research
expenses incurred in
developing a product
for a new business
prior to commencing
the business are not
eligible for the
credit.44
An exception exists
for start-up
businesses that have
in-house research
expenses, provided the
taxpayer’s principal
purpose is to use the
results in the active
conduct of a future
trade or
business.45

To satisfy the
technological
information test, the
process of
experimentation used
to discover
information must
fundamentally rely on
principles of the
physical or biological
sciences, engineering,
or computer
science.46
A taxpayer may use
existing technologies
and rely on existing
principles of those
disciplines.

For
purposes of the
business component
test, a business
component is any
product, process,
computer software,
technique, formula, or
invention that is to
be held for sale,
lease, or license or
used in a trade or
business of the
taxpayer.47
Expenditures for
research related to a
new or improved
function, performance,
reliability, or
quality of a business
component will qualify
for the credit.48
However, research
related to style,
taste, cosmetic, or
seasonal design
factors will not
qualify.49
A taxpayer must be
able to tie the
research for which it
is claiming the credit
to the relevant
business
component.

The
process-of-experimentation
test requires that
substantially all the
activities of the
research constitute
elements of a process
of
experimentation.50
The “substantially
all” requirement is
satisfied only if 80%
or more of the
research activities
constitute elements of
a process of
experimentation.51
A process of
experimentation is
designed to evaluate
one or more
alternatives to
achieve a result where
the capability of
achieving that result,
or the appropriate
design of that result,
is uncertain at the
beginning of the
taxpayer’s research
activities.52
A process may involve
modeling, simulation,
or a systematic trial
and error process.
Uncertainty exists if
the information
available to the
taxpayer does not
establish the
capability or method
for developing or
improving the business
component or the
appropriate design of
the business
component.

To
satisfy the
experimentation
requirement of Sec.
41, the taxpayer
must:

Identify the
uncertainty
regarding the
development or
improvement of a
business component
that is the object
of the taxpayer’s
research activities;

Identify one
or more
alternatives
intended to
eliminate the
uncertainty;
and

Identify and
conduct a process of
evaluating the
alternatives.

In addition to
the six items
discussed above that
are not deductible
under Sec. 174, the
following cannot be
included as qualified
research expenses for
the Sec. 41 research
credit:

Research done
outside the United
States, the
Commonwealth of
Puerto Rico, or any
possession of the
United States;53

Except to the
extent permitted by
the Treasury
regulations,
research with
respect to
internal-use
software (other than
for use in qualified
research or a
related production
process).59

IRS
Challenges to Sec. 41
Credits

The Tax
Court discussed the
requirements for
properly
substantiating the
incremental research
credit in Eustace.60
In that
case, the taxpayer
filed an amended
return claiming the
credit based on
employee interviews
conducted by the
company’s newly hired
tax manager. At trial,
the taxpayer offered
the testimony of six
employees regarding
the nature of their
activities in the
years in question.
Their testimony was
based solely on their
recollection of events
that occurred years
earlier, and no
documentation existed
to corroborate their
testimony. The company
had five departments
and 450 employees. The
Tax Court found the
taxpayer’s
reconstruction of
qualifying expenses to
be “unreliable,
inaccurate,
incomplete, and wholly
insufficient.” The
court found the
pro-forma list of
salaries, supplemented
by testimony,
insufficient for the
taxpayer to meet its
burden of proof that
the salaries were paid
for qualified research
activities.

In
2007, the IRS
designated claims for
tax refunds based on
the Sec. 41
incremental research
credit as a Tier I
audit issue.61
In announcing the
designation, the IRS
noted that the number
of such refund claims
had continued to rise
and that a growing
number of the claims
were based on
“marketed tax products
supported by studies
prepared by the major
accounting and
boutique firms.” The
IRS further noted that
“these studies are
marketed on a
contingent fee basis
and exhibit one or
more of the following
characteristics:
high-level estimates,
biased judgment
samples, lack of nexus
between the business
component and
qualified research
expenses (QREs), and
inadequate
contemporaneous
documentation.” One of
the items that IRS
auditors examining a
Sec. 41 research
credit claim must
request is a
description “by dollar
amount where these
additional QREs were
deducted on your
original return, i.e.,
cost of goods sold,
capitalized as part of
plant or equipment,
overhead accounts or
claimed and deducted
as research
expenses.”

Schedule
M-3: Line 35, R&E
Costs

Taxpayers
are now required to
report on Part III,
line 35, of Schedule
M-3:

Column (a): The
amount of expenses
included in net
income on a
taxpayer’s financial
statements that are
Sec. 174 R&E
costs;

Columns (b) and
(c): Any difference
in timing
recognition for
financial and tax
purposes and whether
the difference is
temporary or
permanent.

Column (c):
Adjustments for any
amounts treated for
U.S. income tax
purposes as R&E
expenditures that
are treated as some
other type of
expense for
financial accounting
purposes (i.e.,
salaries, supplies,
contract services,
etc.); and

For tax years after
2011, the Schedule M-3
instructions also
require an attachment
that separately states
and adequately
discloses R&D
transactions. The
description should
clearly identify (1)
the account name under
which the Sec. 174
R&E expenses were
recorded in the
financial statements
or books of the
taxpayer and (2) the
amount of the
temporary and
permanent
differences.

The
instructions to the
revised Schedule M-3
provide the following
examples when
disclosing R&D
expenses on line 35,
Research and
development costs.

Example
1:X
incurs $100,000 of
R&D costs that it
recognizes as an
expense in its
financial statements.
X
also incurs $20,000 in
attorney fees to
obtain a patent that
it capitalizes and
amortizes at $2,000
per year in its
financial statements.
X
deducts $120,000 as
Sec. 174 expenditures
on its tax return.

On its Schedule
M-3, X
reports $100,000 as
its R&D expenses
for financial
statement purposes
(column (a)) and
$120,000 of Sec. 174
expenses for tax
purposes (column (d)).
The $20,000 for the
patent acquisition
costs being amortized
for financial
statement purposes is
reported as a
temporary difference
(column (b)). In
addition, on line 28,
Other amortization or
impairment write-offs,
X
reports $2,000 as
amortization expenses
for financial
statement purposes
(column (a)) and a
temporary difference
of ($2,000) (column
(b)), with a deduction
for income tax
purposes of zero
(column (d)).

Example 2:The facts are
the same as in
Example 1, except
that X makes a Sec.
59(e) election to
amortize $80,000 of
the $120,000 of Sec.
174 expenses over 10
years. The remaining
$40,000 is expensed
in the current year
for tax purposes. On
its Schedule M-3, X reports
$100,000 as its
R&D expenses for
financial statement
purposes (column
(a)) and $48,000
[$40,000 + ($80,000
÷ 10 years)]
for tax purposes
(column (d)).

The
temporary difference
of $52,000, which
equals $20,000 for the
patent acquisition
costs capitalized for
financial accounting
purposes, less $72,000
of unamortized Sec.
174 expenses ($80,000
÷10 years × 9
years), is reported as
a temporary difference
(column (b)). X
would report these on
line 35. X
would report
the $2,000 temporary
difference relating to
amortization expenses
as in the preceding
example.

Example 3:X incurs $50,000
of R&D costs
that it recognizes
as an expense in its
financial
statements. X tries to develop
a new machine for
its business that
costs $30,000. The
$30,000 is composed
of $10,000 of actual
costs of material,
labor, and
components to
construct the
machine and $20,000
of research costs
not attributable to
the machine itself.
For financial
accounting purposes, X capitalizes all
$30,000 and
recognizes $6,000 of
depreciation. X’s basis in the
machine for tax
purposes is $10,000,
and the tax
depreciation is
$2,000.

On its Schedule
M-3, X
would report $50,000
as its R&D
expenses for financial
statement purposes
(column (a)) and
$70,000 of Sec. 174
expenses for tax
purposes (column (d)).
X
would report the
$20,000 of research
costs not attributable
to the machine itself
deducted as Sec. 174
R&E expenditures
for tax purposes as a
temporary difference
(column (b)). In
addition, on line 31,
Depreciation, of Part
III of Schedule M-3,
X
would report $6,000 of
depreciation for
financial statement
purposes (column (a))
and $2,000 for tax
purposes (column (d)).
The difference of
$4,000 would be
reported as a
temporary difference
(column (b)).

Example 4:X incurs $10,000
of R&D costs
related to social
sciences that it
recognizes as an
expense in its
financial
statements. Such
costs are not
allowable Sec. 174
costs. On its
Schedule M-3, X would report
the $10,000 as its
R&D costs for
financial statement
purposes (column
(a)) and zero for
tax purposes (column
(d)). The $10,000
permanent difference
would also be
reported (column
(c)).

If
the costs are
otherwise deductible,
X
would include the
$10,000 in column (d)
on line 37, Other
expense/deduction
items with
differences, and zero
in column (a) of the
same line. X
would include the
$10,000 permanent
difference in column
(c).

Example 5:X
incurs $100,000 of
R&D costs that it
recognizes as an
expense for both
financial and tax
purposes. X
claims a research
credit of $1,000 and
does not make the
reduced credit
election under Sec.
280C.

X would report
$100,000 of R&D
expenses for
financial accounting
purposes in column
(a). As discussed
above, the research
credit reduces the
Sec. 174 tax
deduction available
to X dollar for
dollar. Therefore, X would report
$99,000 in column
(d) and report the
$1,000 difference as
a book-tax
difference. The
instructions to
Schedule M-3 provide
that the taxpayer
should report the
difference as a
temporary difference
in column (b). Since
this is not a timing
difference, it may
be more appropriate
to report the
difference in column
(c) (permanent
difference).

Sec. 118 Receipts
Reportable on Schedule
M-3

Rationale
for Exclusion

The origin of Sec.
118’s exclusion of
nonshareholder
contributions from
corporate income can
be found in Edwards
v. Cuba Railroad Co.62
In this case, the
Cuban government gave
cash and property to a
corporation to build a
railroad. The U.S.
Supreme Court decided
that the funds did not
meet the definition of
income and therefore
were nontaxable.
However, in Texas
& Pacific
Railway
Co.,63
the Supreme Court
ruled that the funds
the corporation
received from the
federal government
were taxable because
they were to replace
lost income rather
than to be used for
capital expenditures.
Only actual
contributions to a
corporation’s capital
are not included in
income.

Even in cases in
which the transfer
was nontaxable, the
results were not
certain because of
the basis issue.64 Since the
original basis rules
did not distinguish
shareholder from
nonshareholder
contributions, the
corporations argued
that they were
entitled to
carryover basis for
the property
transferred as
capital
contributions. The
courts ruled in the
taxpayers’ favor.
Therefore, these
transactions were
truly nontaxable
rather than tax
deferred.

Subsequently, in
Glenshaw
Glass,65
the Supreme Court
adopted a definition
of income that
includes all increases
or accretions in
wealth. Given this
broad definition, it
is questionable
whether contributions
such as the ones in
Cuba
Railroad would
be ruled nontaxable
today. More important,
Sec. 118(a) provides
that corporations do
not recognize income
on the receipt of a
contribution to
capital. The
contribution can be
from a shareholder or
nonshareholder.
Permissible
nonshareholders
include government
units and civic
groups.66

Contributions to
capital do not include
payments for goods or
services, or payments
to induce the taxpayer
to limit production.
They also do not
include contributions
in aid of construction
or any other
contributions made by
a current or potential
customer.67
However,
certain contributions
in aid of construction
of regulated public
utilities that provide
water or sewerage
disposal services are
considered
contributions to
capital.68

Distinguishing
nontaxable
contributions from
taxable payments for
goods and services can
be difficult. To make
a capital
contribution, the
transferor must have
intended the transfer
to be a
contribution.69
For contributions from
government agencies,
intent may be
determined from the
laws and regulations
that authorized the
transfer. For other
transfers, a
facts-and-circumstances
test is used. In Chicago,
Burlington &
Quincy Railroad,70
the Supreme Court
identified the five
characteristics of a
nontaxable
contribution:

It must be a
permanent part of
the corporation’s
working capital
structure;

It must not be
compensation for
services;

It must be
bargained for;

The benefit to
the corporation must
be commensurate with
the value of the
property
contributed; and

The
asset contributed
ordinarily will be
used in or
contribute to the
production of
additional income.

At the same time
it enacted Sec. 118,
Congress enacted
Sec. 362(c), which
requires that for a
cash contribution to
capital, the basis
of property acquired
with the cash within
12 months of the
contribution must be
reduced by the
amount of cash
contributed. If the
corporation does not
use the cash to
acquire property
within 12 months, it
must reduce the
basis of other
property it owns by
the amount
contributed. These
rules turn the
originally tax-free
transaction into a
tax-deferred
transaction. The
corporation will
recognize additional
income as the result
of either reduced
depreciation or gain
on the disposition
of the contributed
property.

IRS
Challenges to Sec. 118
Exclusions

Sec.
118 was designated a
Tier I audit issue in
part because
noncorporate entities
such as partnerships
were excluding
nonowners’
contributions from
income. Sec. 118
specifically applies
to corporations, and
there is no comparable
provision in
subchapter K.
Therefore, it is the
government’s position
that noncorporate
entities cannot
benefit from Sec. 118
and that all
contributions to
noncorporate entities
must be included in
income.71
Although the
government does not
cite the case, this
conclusion is based on
the expanded
definition of income
contained in Glenshaw
Glass.

Probably the
most important
reason that Sec. 118
became a Tier I
audit issue was that
certain corporations
were attempting to
exclude payment for
services or future
services from
income. For example,
in LMSB-04-0307-026,72 the government
directed field
examiners to
challenge any
telecommunications
corporations that
were excluding
receipts from the
universal service
fund (USF) from
income. This fund
reimburses a
telecommunications
corporation for
extending services
to customers that
are difficult to
reach or are not
profitable at
traditional fees.
Since these payments
are meant to
encourage the
corporation to
provide services,
they are considered
income and not a
contribution to
capital.

The government
recently prevailed on
the USF issue in Sprint
Nextel
Corp.73
The district court
concluded that a
consolidated group of
telecommunications
companies was not
entitled to a refund
of taxes paid on
amounts received from
the Federal
Communications
Commission for
providing reasonably
priced telephone
service to consumers
in high-cost areas.
The court rejected the
argument that the
payments were
nonshareholder
contributions to
capital and concluded
that they were
intended to supplement
income.74

The government
has identified three
other specific
abuses in Tier I
directives. One is
the exclusion of
environmental
remediation payments
related to
underground storage
tanks from state and
local entities.75 The corporation
deducts the cost of
the remediation,
excludes the
reimbursement, and
reduces the basis in
an underground
storage tank. It is
the government’s
position that the
reimbursement is
either a reduction
in deductible
expenses or included
in income without an
offsetting basis
reduction in the new
storage tank.
Another issue
relates to state and
local tax
incentives. Many
states offer a
reduction in taxes
due, to encourage
businesses to
relocate to their
state or to expand
existing businesses.
According to the
government, a
marketed corporate
tax strategy entails
deducting the full
amount of state and
local taxes,
excluding these
incentives from
income under Sec.
118, and reducing
the basis in a
depreciable asset.
The proper
treatment, according
to the government,
is for these
incentives to reduce
the tax expense
under Sec. 164.76The third issue
relates to bioenergy
program payments
from state and local
governments. The IRS
takes the position
that these payments
are not compensation
for capital asset
acquisition. Rather,
the payer intends
them to compensate
the taxpayer for
operating costs
incurred as a result
of purchases of
commodities in the
taxpayer’s bioenergy
production process.
Thus, they do not
qualify as a
contribution of
capital and should
be included in income.77

The Sec. 118 issue
is slightly more
complex where a
taxpayer receives a
reduction in taxes or
similar incentive
instead of a payment
from the payer. In the
case of an expense
reduction, taxpayers
can treat the
incentive in two basic
ways. The first way is
to treat the expense
reduction as income
that is excludible
under Sec. 118 and to
take a corresponding
reduction in the basis
of one or more assets.
The taxpayer also
takes a deduction for
the amount of taxes it
would have owed absent
the incentive. The
second alternative is
to simply net the tax
reduction against a
current or future tax
expense (the
equivalent of
including the amount
of the incentive in
income) and not reduce
the basis of any
property. The
following example
illustrates the
difference in
results:

Example
6:A
Corp. is promised a
real estate tax
holiday from paying
$100,000 in property
taxes over the next
five years if the
company relocates its
business to community
X.
Should A
(1) exclude the
$100,000 from income
under Sec. 118 and
reduce its basis in
the building that it
will construct in
X,
or (2) reduce its
total property tax
expense over the next
five years by the
amount of taxes it
doesn’t have to
pay?

In scenario
1, A
will have a reduced
depreciation expense
of $100,000, but this
reduction will be
spread over the
depreciation period of
the property with the
basis reduction. It
will have a property
tax deduction of
$100,000 over the next
five years. In
scenario 2, A
will not have a
reduced depreciation
expense and will not
have a tax deduction
for the $100,000 in
property taxes.

Given the time
value of money,
scenario 1 is
preferable. However,
the IRS has taken
the position that
the property tax
abatement does not
meet the definition
of a Sec. 118
contribution that a
taxpayer can exclude
with a corresponding
basis reduction.
Presumably, the IRS
plans to use the new
Sec. 118 disclosures
to gain a better
understanding of the
extent to which
taxpayers are
abusing the Sec. 118
exclusion.

In an audit, the
IRS identifies
improper Sec. 118
claims by examining
the difference in
the income reported
for financial and
tax purposes. If a
corporation does not
clearly label the
items related to a
Sec. 118 claim,
discovery is
difficult. Another
way to identify this
issue on audit is by
examining the
depreciation
deduction. Because
contributed property
has a reduced tax
basis under Sec.
362(c), there likely
is a difference in
the amount of
depreciation claimed
for book and tax
purposes. Since
there are numerous
reasons that the
amounts of
depreciation differ,
discovering a basis
reduction that is
due to a Sec. 118
claim by examining
the depreciation
deductions is also
extremely difficult.
Requiring
corporations to
identify Sec. 118
contributions will
enable the IRS to
more easily identify
corporations
receiving these
transfers.

Schedule
M-3: Line 36, Sec. 118
Exclusion

Since
2008, Schedule M-3
corporate filers have
been required to
disclose whether a
position was taken on
the return
characterizing any
amount as a
contribution to
capital by checking a
box on line 10 of Form
1120, Schedule B,
Additional Information
for Schedule M-3
Filers. Apparently the
IRS felt the need to
expand this reporting
requirement with a
detailed explanation
by adding line 36 to
Part III of Schedule
M-3.

Unfortunately, the
instructions for
reporting Sec. 118
exclusions are
minimal, saying only
that any inducements
received in the
current year and
treated as
contributions to the
capital of a
corporation by a
nonshareholder must be
reported on this line.
The corporation meets
the reporting
requirement by
attaching a schedule
that separately
states, adequately
discloses, and
identifies the fair
market value of land
or other property,
including cash,
received from any
nonshareholder,
including a government
unit or civic group.
The schedule should
also list inducements
to locate or expand
existing operating
facilities in a
particular state,
municipality,
community, or locality
and inducements that
include refundable or
transferable tax
credits, including
transferable credits
that the corporation
sold. The corporation
must attach an
explanation even if it
reports no dollar
amount. It is
important to show
receipts as negative
numbers because the
Sec. 118 exclusions
are reported in Part
III, which is a
reconciliation of
expenses and
deductions rather than
income items.

The following
examples illustrate
these reporting
requirements.

Example
7:Q
Corp. receives
$200,000 in payments
from the USF to
provide
telecommunications
service to schools and
libraries, which pay a
discounted rate that
does not cover Q’s
cost of providing the
service. Payments are
treated as income for
financial accounting
purposes and as a
contribution to
capital by a
nonshareholder with a
corresponding
reduction in the basis
of the assets for tax
purposes. Q
reports the Sec. 118
income on Part III,
line 36a, as a
negative number and
then excludes the
amount from income on
line 36b. The tax
depreciation expense
will be reduced by
$200,000 over the
useful life of the
telecommunication
equipment. The
corporation may be
required to report
this position on
Schedule UTP,
Uncertain Tax
Positions Statement,
since the IRS has
taken the position
that these payments
are not eligible for
the Sec. 118
exclusion.

Example
8: The
state orders
A Corp., a
petroleum distributor,
to remove and replace
a leaking underground
storage tank. A
incurs removal costs
for the old tank of
$250,000 and installs
a new tank costing
$300,000. A
receives a $100,000
cash payment from the
EPA’s Leaking
Underground Storage
Tank Trust Fund. A
deducts $150,000 for
removal costs on its
financial statements
but deducts $250,000
for removal costs on
its tax return and
reduces its basis in
the new tank by
$100,000 under Sec.
118. The $150,000
deduction is shown on
line 36a, and the
$100,000 is reported
on line 36b. The tax
depreciation expense
will be reduced by
$100,000 over the
useful life of the
storage tank. As in
Example 7, the
corporation may be
required to disclose
the item on Schedule
UTP.

Example
9:W
Corp. received title
to five acres of land
from municipality
V
on the condition that
W
build and operate a
megastore on the land
for a period of not
less than 10 years.
The fair market value
of the land is
$500,000 and is
recorded for both
financial accounting
and tax accounting as
a nonshareholder
contribution to
capital. The land has
a $500,000 basis for
financial accounting
and a zero tax basis.
Since land is not
depreciable, there is
no book-tax adjustment
to report on Schedule
M-3. However, the
instructions indicate
that W
should attach a
schedule to line 36
describing the asset
received, its fair
market value, and the
government unit making
the contribution.

Conclusion

Taxpayers were
given little lead time
to comply with the new
Schedule M-3 reporting
requirements for the
2010 tax year. As a
result, many taxpayers
may be required to
make accounting method
changes or file
amended tax returns
once they discover
issues related to
complying with the new
Sec. 174 and Sec. 118
disclosure
requirements. Recent
IRS court victories on
the Sec. 118
nonshareholder capital
contribution issue may
prompt taxpayers that
have previously
excluded these amounts
from income to file
amended returns to
recast these
transactions as
taxable rather than
excludible income.

Taken together with
the new Schedule UTP
reporting requirements
for uncertain tax
positions,78
the new disclosures on
the Schedule M-3
require greater
transparency and
increased information
flow that the IRS says
will likely lead to
“speedier issue
resolution and greater
efficiency and
certainty”79
during an audit.
Whether taxpayers who
make these disclosures
will have audit issues
resolved more timely
and quickly remains to
be seen.

Footnotes

1
Filers of Forms 1120,
U.S. Corporation
Income Tax Return;
1120-L, U.S. Life
Insurance Company
Income Tax Return;
1120-PC, U.S. Property
and Casualty Insurance
Company Income Tax
Return; and 1120-S,
U.S. Income Tax Return
for an S
Corporation.

71See
LMSB-04-1106-016
(12/28/06). See also
LMSB-04-1007-069
(10/19/07),
which states there is
no common law
exclusion for
contributions to
noncorporations.
However, it has been
reported that the
government might
reconsider permitting
the exclusion for
government incentive
grants (see Elliott,
“Treasury Might
Consider Exclusion for
Government Grants to
Partnerships,” 2011
TNT 8-2 (January 12,
2011). The issue is
also before the Tax
Court.

Cherie
Hennig is a
professor at the
University of
North
Carolina–Wilmington
in Wilmington,
NC. Edward
Schnee is the
Hugh Culverhouse
Professor of
Accounting and
director of the
MTA Program at
the University
of Alabama in
Tuscaloosa, AL.
Blaise Sonnier
is a professor
at Florida
International
University in
Miami, FL. For
more information
about this
article, contact
Prof. Hennig at
hennigc@uncw.edu.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

Magazine

Don’t get lost in the fog of legislative changes, developing tax issues, and newly evolving tax planning strategies. Tax Section membership will help you stay up to date and make your practice more efficient.